Diversification in Lottery-Like Features and Portfolio Pricing Discounts

Abstract

Why do portfolios often trade at discounts relative to the sums of their components? I provide a novel explanation based on the prospect theory. I extend the model of Barberis and Huang (2008) and consider multiple assets which may or may not produce extreme positive payoffs together. My model predicts that when these assets do not produce extreme payoffs together, a portfolio consisting of them will trade at a discount relative to the market value when they are traded alone. I present three sets of empirical evidence to support this prediction and provide a novel and unifying explanation for the closed-end fund puzzle, the announcement returns of mergers and acquisitions, and conglomerate discounts.

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